CMA Part 2 Financial Decision Making Study Unit 2 - Ratio Analysis Ronald Schmidt, CMA, CFM Jim Clemons, CMA Study Tip • Look at your weekly routine (schedule) and see what can be eliminated or at least suspended for a while. I.e. watching a TV show that you can really live without. Once you have created more time in your schedule, see about rearranging your schedule to allow for some quality study time (and place). • Find a comfortable and quiet place to study with good lighting and little distractions (try avoiding your own bed; it is very tempting to just lie down and take a nap). • f you have a family, you will need to make them a part of this process. They need to be supportive of what you are doing. Exam topics • Part 2 – Financial Decision Making • 4 hours, 100 multiple-choice questions and two 30minute essay scenarios • Financial statement analysis (25%) • Corporate finance (25%) • Decision analysis and risk management (25%) • Investment decisions (20%) • Professional ethics (5%) Ratio Analysis “While financial statements summarize the past performance of an organization, they also can provide users with valuable insights into future performance. Financial statement analysis is performed by stockholders and creditors and is also an important tool for management accountants and financial analysts to use to better understand their company’s competitive position.” Ratio Analysis Remember the exam tests all the ratios and other analytical tools used to evaluate an organization’s financial health, including coverage of analytical issues in financial accounting, such as foreign currency fluctuations, off -balance sheet financing, U.S. GAAP versus. IFRS, and fair value accounting Liquidity Ratios • Liquidity is the firm’s ability to pay its current obligations as they come due. - Short run – How easy is it to convert assets to cash. • Liquidity ratios relates liquid assets to current liabilities. – Current assets – converted to cash within 1 year or operating cycle. • Current asset ratios – Firm’s ability to operate in short term. • Current assets/liabilities are shown in descending order of liquidity. Remember Common-size statement s recast all items in a particular financial statement as a percentage of a selected (usually the largest and most important) item on the statement. These statements can be used to: • Compare elements in a single year’s financial statements. • Analyze trends across a number of years for one business. • Compare businesses of differing sizes within an industry (such as Wal-Mart to Target). • Compare the company’s performance and position with an industry average. Common-size statements are useful when comparing businesses of different sizes because the financial statements of a variety of companies can be recast into the uniform common-size format regardless of the size of individual elements. Also from our last class Cash is a company’s most liquid resource, and therefore it affects liquidity, operating capability, and financial flexibility. According to the Financial Accounting Standards Board (FASB) Statements of Financial Accounting Standards (SFAS) No. 95, Statement of Cash Flows “must report on a company’s cash inflows, cash outflows, and net change in cash from its operating, financing, and investing activities during the accounting period, in a manner that reconciles the beginning and ending cash balances.” The statement helps interested parties determine if an entity needs external financing or is generating cash fl ows, meeting obligations, and paying dividends. Sometimes companies with high income still can have a negative cash flow. What is a ratio? A ratio is a comparative relationship between two (or more) financial statement amounts. Ratios provide incremental information about the financial health of the company beyond the raw amounts presented in the financial statements. Financial ratios are commonly used for three types of inferences: – Inferences on liquidity, solvency, and operations – Inferences on capital structure – Inferences on profitability. Liquidity Liquidity is a relative measure of the proximity to cash of the assets and liabilities of the company and is an indication of company’s ability to meet its short-term obligations. Since most of the liabilities of a company (except unearned revenue) are paid in cash, a good measure of this ability is how rapidly a company could convert its other assets into cash, if the need arises. Liquidity Ratios • Liquidity is the firm’s ability to pay its current obligations as they come due. - Short run – How easy is it to convert assets to cash? • Only a few types of assets can be converted quickly to cash; hence only those are used in computing the short-term liquidity ratios Liquidity Ratios • Liquidity ratios relates liquid assets to current liabilities. – Current assets – converted to cash within 1 year or operating cycle. • Current asset ratios – Firm’s ability to operate in short term. • Current assets/liabilities are shown in descending order of liquidity. Liquidity Ratios – Working Capital • Working capital is a measure of a company’s ability in the short run to pay its obligations. It looks at short-term financial health. Working capital is calculated as shown: Current assets – Current Liabilities – How much capital is left after paying current obligations. Liquidity Ratios – Net Working Capital • Net Working Capital “ratio” = Cur. Assets – Cur. Liab./Total Assets – Most conservative of working capital ratios. SU 2.1 Question 1 Given an acid test ratio of 2.0, current assets of $5,000, and inventory of $2,000, the value of current liabilities is A. $1,500 B. $2,500 C. $3,500 D. $6,000 SU 2.1 Question 1 Answer Correct Answer: A The acid test, or quick, ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. Current assets equal the quick assets plus inventory and prepaid expenses. (This question assumes that the entity has no prepaid expenses.) Given current assets of $5,000, inventory of $2,000, and no prepaid expenses, the quick assets must be $3,000. Because the acid test ratio is 2.0, the quick assets are double the current liabilities. Current liabilities therefore are equal to $1,500 ($3,000 quick assets ÷ 2.0). Incorrect Answers: B: Dividing the current assets by 2.0 results in $2,500. Current assets includes inventory, which should not be included in the calculation of the acid test ratio. C: Adding inventory to current assets rather than subtracting it results in $3,500. D: Multiplying the quick assets by 2 instead of dividing by 2 results in $6,000. SU 2.1 Question 2 A company has a current ratio of 1.4, a quick, or acid test, ratio of 1.2, and the following partial summary balance sheet: Cash $ 10 Accounts receivable ___ Inventory ___ Fixed assets ___ Total assets $100 Current liabilities $___ Long-term liabilities 40 Stockholders’ equity 30 Total liabilities and equity $___ SU 2.1 Question 2 (continued) The company has an accounts receivable balance of A. B. C. D. $26 $36 $66 $100 SU 2.1 Question 2 Answer Correct Answer: A Total assets equal total liabilities and equity. Hence, if total assets equal $100, total liabilities and equity must equal $100, and current liabilities must equal $30 ($100 – $40 – $30). Because the quick ratio equals the quick assets (cash + accounts receivable) divided by current liabilities, the quick assets must equal $36 ($30 × 1.2 quick ratio), and the accounts receivable balance is $26 ($36 – $10 cash). Incorrect Answers: B: The quick assets equal $36. C: The sum of the quick assets and current liabilities equals $66. D: Total assets equal $100. Remember! Current assets are defined as cash or other liquid investments, such as inventory and accounts receivable (A/R), that can be converted to cash within a year. Current liabilities are obligations that will be paid within a year, such as accounts payable and notes and interest payable. A positive value of working capital indicates that there are enough current assets to cover current obligations. Current measures of working capital can be compared to previous measures to determine if there has been a change that should cause concern. Liquidity Ratios - Current Ratio • The current ratio measures the degree to which current assets cover current liabilities. • A higher ratio indicates greater ability to pay current liabilities with current assets, thus greater liquidity. Liquidity Ratios • Current ratio = Current Assets / Current Liabilities • Most common liquidity measurement – Low ratio = Possible liquidity problems – High ratio = Management not investing assets • Should be proportional to the operating cycle. – Shorter operating cycles may justify lower ratio. • Converting to cash quicker. • Evaluate A/R and inventory turn • LIFO lowers ratio. Remember! There are limitations to using the current ratio to assess liquidity. Because cash is the only acceptable means of payment, it is important to consider the composition of current assets and determine whether those listed as current assets can be converted to cash readily. For example, if prepaid expenses compose most of the current assets, the current ratio overstates the liquidity of the company because the prepaid expenses cannot be converted to cash to settle the liabilities. Also, the current ratio cannot predict or indicate patterns of future cash flows, nor can it measure the adequacy of future liquidity. If there is a significant amount of A/R from one customer and that customer files for bankruptcy, there would be significant delay in receiving the payment. Even though the current ratio is high because of the receivables, the debt-paying ability of the company is compromised due to the noncollection of a significant receivable. Liquidity Ratios – Quick Ratio • Quick ratio – (Acid test) = Cash + Mkt Securities + Net receivables / Current liabilities – Avoids inventory valuation issues. – Conservative approach. The quick ratio , or acid-test ratio, examines liquidity from a more immediate aspect than does the current ratio by eliminating inventory from current assets. The quick ratio removes inventory because it turns over at a slower rate than receivables or cash and assumes that the company will be able to sell the items to a customer and collect cash. Liquidity Ratios – Other • Cash ratio = Cash + Mkt Securities/Current Liab. The cash ratio analyzes liquidity in a more conservative manner than the quick ratio, by looking at a company’s immediate liquidity. The cash ratio compares only cash and marketable securities to current liabilities, eliminating receivables and inventory from the asset portion. Liquidity Ratios – Other • Cash Flow ratio = C/F from Operations/Cur. Liab. The cash flow ratio, shown next, measures a companies ability to meet its debt obligations with cash generated in the normal course of business. Liquidity Ratios – Other consideration • Liquidity of Current Liabilities – The ease of issuing new debt or structured (convertible, puttable, callable, etc.) funds. – Firms ability to borrow is usually a function of size, reputation, creditworthines, and capital levels. – Usually a combination of asset liquidity and liability liquidity SU 2.2 – Practice Question 1 Bond Corporation has a current ratio of 2 to 1 and a quick ratio (acid test) of 1 to 1. A transaction that would change Bond’s quick ratio but not its current ratio is the A Sale of inventory on account at cost. B Collection of accounts receivable. C Payment of accounts payable. D Purchase of a patent for cash. SU 2.2 – Practice Question 1 Answer Correct Answer: A The quick (acid test) ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. The current ratio is equal to current assets divided by current liabilities. The sale of inventory (not a quick current asset) on account increases accounts receivable (a quick asset), thereby changing the quick ratio. The sale of inventory on account, however, replaces one current asset with another, and the current ratio is unaffected. Incorrect Answers: B Neither ratio is changed. C The current, not the quick, ratio changes. D Both decrease. SU 2.2 – Practice Question 2 Fact pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account. Depoole’s payment of a trade account payable of $64,500 will A Increase the current ratio, but the quick ratio would not be affected. B Increase the quick ratio, but the current ratio would not be affected. C Increase both the current and quick ratios. D Decrease both the current and quick ratios SU 2.2 – Practice Question 2 Answer Correct Answer: C Current assets consist of more assets than quick assets; thus, if quick assets exceed current liabilities, then current assets do also. It can also be concluded that both ratios are greater than 1. An equal reduction in the numerator and the denominator, such as a payment of a trade payable, will cause each ratio to increase. Incorrect Answers: A The current ratio and the quick ratio will increase. B The current ratio and the quick ratio will increase. D The current ratio and the quick ratio will increase. SU 2.2 – Practice Question 3 The following transactions occurred during a company’s first year of operations: I. Purchased a delivery van for cash II. Borrowed money by issuance of short-term debt III. Purchased treasury stock Which of the items above caused a change in the amount of working capital? A I only. B I and II only. C II and III only. D I and III only. SU 2.2 – Practice Question 3 Answer Correct Answer: D Working capital is computed by deducting total current liabilities from total current assets. The purchase of a delivery van for cash reduces current assets and has no effect on current liabilities. The borrowing of cash by incurring short-term debt increases current assets by the same amount as it increases current liabilities; hence, it will have no effect on working capital. The purchase of treasury stock decreases current assets but has no effect on current liabilities. Thus, the purchases of the van and treasury stock affect working capital. Incorrect Answers: A The purchases of the van and treasury stock affect working capital. B The purchases of the van and treasury stock but not the issuance of short-term debt affect working capital. C The purchases of the van and treasury stock but not the issuance of short-term debt affect working capital. Sensitivity Analysis “It is important to gauge how sensitive these ratios are to changes in their components. An increase in the numerator of a ratio will increase the value of the ratio, whereas an increase in the denominator of a ratio will reduce the value of the ratio, and vice versa. Since a higher number is preferable for these ratios, a decrease in the numerator or an increase in the denominator adversely affects the ratio and inferences made.” Remember! An increase in liabilities would adversely affect the ratio, whereas an increase in current assets or cash flows (the term in the numerator) would improve the ratios. The amount of increase or decrease in a particular ratio depends on the value of the ratio. • An equal increase in both the numerator and the denominator of the ratio would worsen the ratio, if the ratio is greater than 1. • An equal decrease in both the numerator and denominator would improve a ratio that is greater than 1. SU 2.3 – Activity Measures Another way to analyze liquidity is to focus on the management of key current assets, namely inventory and A/R. A manager successfully managing inventory and collecting A/R in a timely manner also will be improving liquidity. Operating activity analysis is done over a period of an operating cycle—the time elapsed between when goods are acquired and when cash is received from the sale of the goods. – Measures how quickly noncash assets are converted to cash. – Over a period of time. Includes I/S data. – The Balance Sheet data should always be an average SU 2.3 - Activity Measures - Receivables • A/R Turnover = Net credit sales / Ave. A/R – Efficiency of A/R collections. – High ratio : Customers pay promptly. – Highly seasonal should use monthly A/R average. One of the assumption of this ratio is that sales occur evenly throughout the year, therefore average A/R can be estimated using the average of beginning and ending A/R balances. When sales are seasonal or uneven, the beginning and ending balances may not be indicative of the average A/R balance. This is one of the reasons that most retailers have a fiscal year ending on January 31 and not December 31, because the sales in that industry are seasonal. Activity Measures - Factoring of Accounts Receivables Some firms, in attempt to raise cash, borrow using A/R as collateral. This is called factoring of accounts receivable and is done to avoid recording a payable or a liability. Doing this enables the firm to borrow cash without showing the corresponding liability; hence such transaction is called “off-balance sheet financing.” Activity Measures A/R turnover also can be analyzed in days instead of times • Days’ Sales Outstanding (DSO) • DSO = Days in year / AR turnover – Average collection period in days. – May use 365, 360 or 300 days – Compared to credit terms to determine if customers pay within terms. Activity Measures • Inventory turnover = COGS / Ave. Inventory – Measures efficiency of inventory management. – High ratio : Quicker inventory turns • Inventory not obsolete, not carrying excess. – Highly seasonal should use monthly Inv. average. – LIFO valuation not comparable to other methods. – Inventory turnover is industry specific. • Grocery vs. Concrete • Days’ Sales in Inventory = Days in year/Inv. Turnover – How many days sales are tied up in inventory. Activity Measures Any judgment regarding payment of current liabilities should be made in light of the degree of urgency of payment. Several measurements can be made to assess the company’s policy in paying off current liabilities. Such analysis could be used by new suppliers to assess the timeliness and creditworthiness of the company. Activity Measures - Payables • Accounts Payable Turnover = Purchases / Ave. AP – Highly seasonal should use monthly Payables average. • Days’ Purchases in Accounts Payable (DPO) • DPO =Days in year / AP Turnover – Compared to credit terms to determine if the firm is paying within terms. Continued Activity Measures - Payables Measurement of days’ purchases in accounts payable usually indicates the payment terms that the company has with its suppliers, assuming that the company is not in default on its payments. Analysts may find it impossible to determine credit purchases. A reasonable approximation is to substitute total purchases instead of credit purchases. Total purchases can be determined by adjusting the cost of goods sold by the changes in inventory balance. A large ratio would indicate that the company either has good relationship with its suppliers and enjoys liberal payment plan or is delinquent in making payments. Activity Measures • Operating Cycle = DSI + DSO – The amount of time to convert inventory to cash. – Figure 2-2 Page 67 • Cash Cycle = Operating Cycle – DPO – Is the days that cash is tied up as another asset. Activity Measures • Fixed Assets Turnover Ratio = Net Sales / Ave. Net PP&E – How efficiently the company deploys its investment in plant assets to generate revenues. – Higher turnover is preferable. – Affected by the capital intensiveness of the company and its industry, by the age of the assets, and by depreciation method used. • Total Assets Turnover Ratio = Net Sales / Ave. Total Assets – Higher turnover is preferable. – Exclude assets that do not relate to sales. Ex: investments Sample Financial Data Sample Financial Data Calculate: Current Year Net Working Capital Calculate: Current Year Net Working Capital Current Assets – Current Liabilities $760 – 390 = $370,000 Calculate: Current Year Current Ratio Calculate: Current Year Current Ratio Current Assets / Current Liabilities 760 / 390 = 1.949 Calculate: Current Year Quick (Acid Test) Ratio Calculate: Current Year Quick (Acid Test) Ratio Cash + Mkt Securities + Net Rec / Current Liabilities (325 + 165 + 120 + 55) / 390 = 1.705 Calculate: Current Year Cash Ratio Calculate: Current Year Cash Ratio Cash + Mkt Securities / Current Liabilities (325 + 165) / 390 = 1.256 Calculate: Current Year Net Working Capital Ratio Calculate: Current Year Net Working Capital Ratio Current Assets - Current Liabilities / Total Assets (760 – 390) / 1,800 = .206 Calculate: CY AR Turnover * All sales are 365 day credit sales Calculate: CY AR Turnover Net Credit Sales / Ave. AR 1,800 / ((120 + 115) /2) = 15.3 Calculate: CY DSO * All sales are 365 day credit sales Calculate: CY DSO Days in Year / AR Turnover 365 / 15.3 = 23.9 Days Calculate: CY Inventory Turnover * All sales are 365 day credit sales Calculate: CY Inventory Turnover COGS / Ave. Inventory 1650 / (85 +55)/2 = 23.6 Calculate: CY DSI Days in Year / Inventory Turnover 365 / 23.6 = 15.5 Days Calculate: CY AP Turnover Purchases *CY = $1,760,000 PY = $1,440,000 Calculate: CY AP Turnover Purchases / Ave AP $1,760 / (150 + 75) /2 = 15.6 Calculate: CY DPO Calculate: CY DPO Days in Year / AP Turnover 365 / 15.6 = 23.4 Days Calculate: CY Operating Cycle Calculate: CY Operating Cycle DSO + DSI 23.9 + 15.5 = 39.4 Days Calculate: CY Cash Cycle Calculate: CY Cash Cycle Operating Cycle - DPO 39.4 – 23.4 = 16.0 Days Calculate: CY Fixed Asset Turnover Ratio Calculate: CY Fixed Asset Turnover Ratio Net Sales / Ave PP&E $1,800 / (915+ 845)/2 = 2.05 Calculate: CY Total Asset Turnover Ratio Calculate: CY Total Asset Turnover Ratio Net Sales / Ave Total Assets $1,800 / (1,800 + 1,600)/2 = 1.06 SU 2.4 - Solvency Solvency is the degree to which the current assets of an organization exceed the current liabilities of the organization. Solvency describes the ability of an organization to meet its long-term fixed expenses and to meet long-term expansion and growth. Organizations can calculate the net liquid balance (NLB) as a measure of solvency by adding cash and cash equivalents to short-term investments, then subtracting notes payable. 2.4 – Solvency • Solvency is a firm’s ability to pay its noncurrent obligations as they come due… • Long-run as opposed to liquidity which focuses on short-term (current items) • Firms capital structure incl. • Liabilities (external) – Long-term and short-term debt • Equity – (internal) – Residual • Capital decisions have consequences • > debt = > risk = > cost of capital • > equity = < ret. on equity • Which det. deg. of leverage 2.4 – Solvency • Debt = creditors interest – = contractual obligations – Ret > cost of debt = > equity • Equity = permanent capital – Ret. uncertainty even with Pre. Stock 2.4 – Solvency • Capital Structure Ratios – Total Debt to Total Capital Ratio • TTL Debt/TTL Capital (Debt & Equity) = total leverage – Debt to Equity Ratio • TTL Debt/Equity = total amount (X) that debt exceeds equity 2.4 – Solvency – Long-term Debt to Equity Ratio • Long-term debt/Equity – ??? – which is better, increase or decrease of Long-term Debt to Equity Ratio, year over year? – Debt to Total Asset Ratio • TTL Liabilities/ TTL Assets – ??? – how is it the same as the debt to total capital ratio? 2.4 – Solvency • Earnings Coverage – Times interest earned ratio • EBIT/Interest Expense • ??? – What does this tell a creditor • Most common mistake – not to add back that years interest payment to NI before taxes – Earnings to Fixed Charges Ratio • EBIT + Interest portion of operating leases/Int. exp. + Int. portion of operating leases + Div. on Pre. Stock • More conservative; shows all fixed charges 2.4 – Solvency – Cash Flow to Fixed Charges Ratio • Pre-tax operating cash flow/Int. exp. + Int. portion of operating leases + Div. on Pre. Stock – Eliminates issues associated with accrual accounting SU 2.4 – Practice Question 1 Bond Corporation has a current ratio of 2 to 1 and a quick ratio (acid test) of 1 to 1. A transaction that would change Bond’s quick ratio but not its current ratio is the A Sale of inventory on account at cost. B Collection of accounts receivable. C Payment of accounts payable. D Purchase of a patent for cash. SU 2.4 – Practice Question 1 Answer Correct Answer: A The quick (acid test) ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. The current ratio is equal to current assets divided by current liabilities. The sale of inventory (not a quick current asset) on account increases accounts receivable (a quick asset), thereby changing the quick ratio. The sale of inventory on account, however, replaces one current asset with another, and the current ratio is unaffected. Incorrect Answers: B Neither ratio is changed. C The current, not the quick, ratio changes. D Both decrease. SU 2.4 – Practice Question 2 Fact pattern: Depoole Company is a manufacturer of industrial products that uses a calendar year for financial reporting purposes. Assume that total quick assets exceeded total current liabilities both before and after the transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account. Depoole’s payment of a trade account payable of $64,500 will A Increase the current ratio, but the quick ratio would not be affected. B Increase the quick ratio, but the current ratio would not be affected. C Increase both the current and quick ratios. D Decrease both the current and quick ratios. SU 2.4 – Practice Question 2 Answer Correct Answer: C Current assets consist of more assets than quick assets; thus, if quick assets exceed current liabilities, then current assets do also. It can also be concluded that both ratios are greater than 1. An equal reduction in the numerator and the denominator, such as a payment of a trade payable, will cause each ratio to increase. Incorrect Answers: A The current ratio and the quick ratio will increase. B The current ratio and the quick ratio will increase. D The current ratio and the quick ratio will increase. SU 2.4 – Practice Question 3 The following transactions occurred during a company’s first year of operations: I. Purchased a delivery van for cash II. Borrowed money by issuance of short-term debt III. Purchased treasury stock Which of the items above caused a change in the amount of working capital? A I only. B I and II only. C II and III only. D I and III only. SU 2.4 – Practice Question 3 Answer Correct Answer: D Working capital is computed by deducting total current liabilities from total current assets. The purchase of a delivery van for cash reduces current assets and has no effect on current liabilities. The borrowing of cash by incurring short-term debt increases current assets by the same amount as it increases current liabilities; hence, it will have no effect on working capital. The purchase of treasury stock decreases current assets but has no effect on current liabilities. Thus, the purchases of the van and treasury stock affect working capital. Study Tip • Try to identify if you are missing most MC questions because you did not know the material or because you did not correctly understand the questions and/or answers. We need to eliminate the later and isolate missed question largely due to lack of material. There is a finite amount of material to know, particularly when you narrow down most common asked questions. • Learn the general concepts first, don't worry about learning the details until you have learned the main ideas. 2.5 – Leverage Types of Leverage Read: Gleim Success Tip on page 51! A company uses leverage in two ways: financial and operating. • Financial leverage is raising capital through debt rather than equity. While debt holders are entitled to interest, the owners share the earnings of the company. Hence, when a company can earn a higher rate of return on its invested capital through its operations than the interest rate on its debt, it could increase the return for its investors by financing the growth of company operations through borrowed capital. • Operating leverage is the existence of fixed operating costs. Because these costs are fixed, the higher the percentage of operating leverage, the greater the effect changes in sales revenues have on operating income. The focus on leverage in this section is on financial leverage. The cost of financial leverage is interest costs, which must be paid regardless of sales. 2.5 – Leverage – Leverage = relative of fixed cost • ??? – which fixed cost? • ??? – what financial statement do we find on? – Deg. of leverage = Pre-fixed-cost income amount/Post-fixed-cost income amount 2.5 – Leverage • Distinguish between variable costing and full-costing • Why do we have to have variable costing for measuring the DOL – Degree of Op. Lev. – Single-Period Version • DOL = Contribution Margin/Operating Income or EBIT • Contribution Margin = ??? • Example page 72 2.5 – Leverage – Degree of Operating Leverage – Perc.-Change Version • %Chng. in Op. Inc. or EBIT/%Chng. in Sales • Example page 52 – Degree of Financial Leverage – Single-Period Version – EBIT/EBT • A variation is the Percentage-change Version Capital Structure – Other considerations Consider that increases in debt create higher fixed costs for interest and principal payments. It also results in a higher debt to equity ratio and, therefore, a less favorable position for long-term debt-paying ability. Decreases in equity, as a result of redemption of stock or losses from operations, also would result in a higher debt to equity ratio and higher risk for the company’s ability to pay long-term debt. Increases in equity, such as those from profits, without corresponding increases in debt would lower the debt to equity ratio, increasing the company’s position for long-term debt-paying ability. Capital Structure – Other considerations Management takes much care to manage the capital structure and its disclosure because of the direct impact it has on the cost of capital and thus on the profitability of the firm. Capital Structure – Other considerations What is Off -Balance Sheet Financing, and how does it affect financial rations? • Off -balance sheet financing is a form of financing in which large capital expenditures are kept off an organization’s balance sheet through various classification methods. • Organizations oft en use off -balance sheet financing to keep their debt to equity and leverage ratios low, especially if the inclusion of a large expenditures would violate debt covenants. • Four of the common techniques employed to achieve off -balance sheet financing are: factoring of A/Rs, special-purpose entities, leases, and joint ventures. Capital Structure – Other considerations Special-Purpose Entities Many firms create special-purpose entities (SPEs) for a “special,” sometimes undisclosed, business purpose. For example: • SPEs may be created to facilitate leasing activities, loan securitizations, R&D activities, or trading in financial derivatives (i.e. Enron). • Because these were created as “separate” entities from the parent corporation, the financials and business transactions of these SPEs were not consolidated with that of the parent. • By excluding such ventures from consolidation, the company is “hiding” significant business risk from investors • • • Capital Structure – Other considerations Leases Firms usually use leases to get use of an asset without having to show it on the balance sheet as an asset and the corresponding liability. If the firm were to purchase the asset, it might have to use cash, thus converting short-term assets into long-term assets and worsening short-term liquidity ratio. Purchasing the asset on credit would increase the firm’s accounts payable, again worsening its short-term liquidity ratios. If the firm were to use long-term financing to purchase, it would worsen the debt to equity or other solvency ratios. A way to avoid any of these adverse consequences on the balance sheet, firms sometimes lease the asset. Generally accepted accounting principles require that a determination be made on whether the lease is an operating lease or a capital lease. When the lease meets one of the four conditions established for capital leases, the lease payments are accounted for as a long-term liability. However, sometimes firms are able to structure a lease so as not to meet any of the four conditions. It can then classify the lease as an operating lease. With an operating lease, the firm is able to obtain the use of the asset without having to record its obligation to pay, thus obtaining off-balance sheet financing. Capital Structure – Other considerations Join Ventures A joint venture is a business entity that is owned, operated, and jointly controlled by a small group of investors with a specific business purpose. • • Sometimes a corporation is a partner in a venture, which allows it to be active in management and involved in decision making but not report the venture on the financial statement of the corporation. An investment in a corporate joint venture that exceeds 50% of the venture’s outstanding shares must be treated as a subsidiary investment, leading to consolidation in the financial statement. However, firms sometimes are careful to hold less than 50% (say 48.5%) of outstanding shares to avoid such consolidation— providing off -balance sheet financing. Study Tip • It is best to review the material right after class when it's still fresh in your memory.